Loaning to friends and relatives is a delicate business, and not simply because of the tension it can cause in your relationships. There are tax issues at play also. If you must loan money to somebody close, here are some tips to do it correctly as far as the IRS is concerned.
Yes, you should charge interest, even to friends and family. If you don’t charge a minimum rate, the IRS will imply interest in the loan and tax you for the interest they assume you are getting. This can happen even if you’re not getting a dime.
Charge Enough Interest
Not only should you charge interest, the amount must be reasonable in the eyes of the IRS. If it's not, the IRS will imply interest at their minimum applicable federal rates (AFRs). To stay on the safe side, always charge the interest rate at or above these AFRs, available on the IRS website. The good news is these interest rates are low and usually lower than the prime interest rate.
Know the Exceptions
If you don’t want to charge interest, you don’t have to IF:
If you don’t charge interest and the loan is used to purchase income-producing property such as capital equipment or to acquire a business, special tax rules apply. In this case it’s good to ask for help.
Get It in Writing
If you expect repayment, put the terms of your loan in writing. There are a variety of basic loan document formats online that you can use. Creating a loan document may seem needlessly formal when dealing with a friend or family member, but it’s important for two reasons:
Document your tax code compliance. By recording the terms and charging a specified interest rate you can show you are within tax code rules.
Avoid misunderstandings. Creating a written document will make it clear that it is a real loan, not an informal gift. Your friend or relative will know that you expect them to pay you back and when you expect repayment.